Certifications

September 29, 2008

Trying to Understand Congress

At "A Dash" we have avoided taking an advocacy position on the proposal popularly known as a bailout or The Paulson Plan. Unlike many other investment bloggers, we have described positions in real time, including plenty of hedges over the last few weeks -- win or lose.

In short, we try to analyze rather than to recommend.

Analyzing the House Decision

Last week we had an inquiry from an astute reader who is very much in tune with the popular sentiment on the Paulson Plan and especially on the GOP attitude. She agreed with all of the standard public opinion arguments -- Paulson helping his pals, taxpayers on the hook for $700 billion in losses and maybe more, various allegations about money going to liberal groups, etc.

Here was my email response:

If
you really want to understand what is happening, read this week’s piece by John
Mauldin. Ideologically he is much, much closer to you than to me. He has a
knack for explaining things, and he has good contacts.

Everything
he describes is something I have written about. Despite the length of the piece
and many contentions, I agree with nearly everything he says. You can
understand it, but you might need to run through it once and then read
again.

We
are in a vicious circle that I call the “death spiral.” There is a school of
thought that maintains that this is a normal functioning of the business cycle,
that we were too highly leveraged, and that we must go through the de-leveraging
process sooner or later. These people, including both academic economists and
bearish market pundits (who are cashing in on short positions and selling
books), have missed a key point.

This
spiral has no natural level at which it will stop. There is no “correct” amount
of leverage. The Mauldin column shows that we are way past any normal level in
many securities.

The
problem is that the average person does not (and cannot) understand this. The
average Congressional Rep can’t either. It is as if we were in one of those
movies where an asteroid was headed
toward earth. Some folks think this is an act of nature or God and will hit us
or not. Others think we should try to send missiles to intercept it. Those
discussing the missile plan are arguing about what color the missile should
be.

Seeking an Analogy: The Asteroid

As an analogy, let us try the Bruce Willis film, Armageddon. We'll take some liberties with the plot to make our point.

Let us suppose that some scientists determined that an asteroid was on a collision course with Earth. The expected force would be similar to a nuclear explosion.

There is a group of scientists who expect the asteroid to hit Earth, with the effect of a nuclear weapon.

Some scientists disagree, using the "157 theorem". They argue that the asteroid will have a minor impact and restore a normal and natural balance.

Others argue that the asteroid will miss earth.

Some contend that an asteroid strike is a matter of nature. We cannot repeal nature!

Some participants in the debate have real estate holdings in caves. They profit from the scare, and encourage it. Others are selling gold.

Some participants in the debate are selling books -- why our scientists failed to see this earlier, why earthlings should buy gold and shotguns, and why we should prepare for disaster.

Some are attempting to destory the asteroid. They want to send up a team to destroy it before it strikes.

There is considerable debate about the best way to deflect the asteroid.

The program to attack the asteroid has a cost, possibly an investment in the future, and possibly a waste of money. It requires granting considerable executive authority.

The media harps on the potential for waste and possible scientific errors. Leading bloggers join in.

The Solution?

Congress meets in emergency session to authorize a plan. The public has no way of determining the merits of the contending scientific arguments. Members of Congress struggle to understand the contending scientific arguments. The legislators have the responsibilty of office. They have two choices:

Put a wet finger to the wind and do what constitutents believe to be the correct scientifict interpretation; or

Make their own determination of the facts.

The President, his top advisors, and the leadership of both parties advocate action.

The Result?

A majority of legislators votes to take no action. What will be, will be. They do not want to face constituents. They have little cover from the popular media.

Everyone agrees that asteroid planning should have taken place eariler. Many pundits pontificate about which agencies were at fault. Few bother to look forward to find a solution.

It is wonderful to live in a democracy. We do not have to deal with tyrants and dictators.

The problem: Looking forward takes strong leadership. It requires the ability to explain consequences before they actually occur. No President gets credit for avoiding problems, since in that case the results never actually happen. It is only when the impact is palpable that public support develops.

Comments

You drastically reduce the leverage allowable and you kill the golden investment banking goose. They have enough political leverage (pardon the pun) and generate enough tax income that it seems unlikely to me.

The government loves the Fed; it gives them power, which governments rarely willingly relinquish, and allows them to inflate at will. The last thing any government wants to do is force itself to be fiscally responsible. Until the country collapses completely (next century, perhaps?), we are stuck with the Fed.

It is relevant not to fix blame at this point, but it is not all that difficult to determine what brought us here, and thus the solution becomes self-evident.

The debt-to-capital ratio of investment banks was allowed to expand to as much as 30-1 (enabled courtesy of the SEC). How about rescinding the rule and firing Mr. Cox?

The biggest fix: rescind mark-to-market and return to fair market value. This was a controversial and widely derided rule when it was put in place just 4 or 5 years ago. It the largest reason we are in this mess. Rescind mark-to-market.

Finally, the Fed reduced interest rates far too much in the wake of 9/11 and left them there far too long. The result: overinflated home prices. Rein in the Fed or abolish it altogether.

If you did these three things I think the bear market would literally vanish overnight.

rb -- it seems to me that reacting to failures will very soon not be enough.

it's been so long since it happened that i'm not sure any of us really understnad the ramifications. but what is under threat is the core purpose of the financial system -- not speculation or investment or capital allocation, but the payments system.

if the CP and bank debt markets don't unjam, we may well see cascading failures within weeks -- too many too fast to broker individually, and not just financials. government will be forced to triage and allow most failures. it is not inconceivable, it seems to me, that basic payments systems -- credit cards, checks -- could fail in the duress.

what i'm saying is that waiting to mop up carries some very serious risks. this is a time for governemtn to be proactive -- which, as prof has pointed out many a-time, is not what they do best.

If this results in handling crises on a case-by-case basis but results in desperate banks willing to give government a sizable equity share that significantly dilutes existing shareholders as well as gives better control over compensation, would you consider that a better outcome? It would certainly have a punitive measure that most would find more agreeable. A deep recession is probably unavoidable anyway now.

Evander -- Check out the last two paragraphs again. This is a story about the failure of leadership -- the problem too tough and the time too short.

BTW - I don't think I have ever commented on "intellectual betters." I frequently suggest that investors would be better off in respecting expertise. When I call in my plumber, for example, I am recognizing his education and experience. I do not feel stupid or inferior as a result. I have been wise enough to know when to respect someone else.

So in other words, we should do what you always advocate, defer to our intellectual betters. They have our best interest at heart and we are just too stupid to know it. The fact that those are the people who caused this problem should be of no concern. The fact that this bill was initially larded with pork should be ignored. I feel so much better now.